~ Investment Strategy

Morning Note 05/12/11

Expectations are high this week for the latest European summit. This strikes me as a triumph of hope over experience. At the end of the latest round of talks, fiscal integration and ECB action will be a bit closer, but the basic picture, that Europe is being forced into a recession by the logic of internal adjustment, and the ECB will do the minimum required to avoid a major crisis in order to force governments towards a fiscal solution, will remain unchanged. One thing that is changing as the ECB hints at a willingness to take further action is the probability of euro breakup — but I have never thought that was remotely possible in the short term in any case (in the long term, anything is possible).

A correspondent asked what I thought would happen in Europe, in the context of piece by Ambrose Evans-Pritchard (http://j.mp/t2gqy5), in which the latter writes: “The crisis can undoubtedly be halted immediately by the ECB. The bank can reflate Club Med off the reefs. It chooses not to act for political reasons because this mean higher inflation for Germany. That is the dirty secret. Everybody must be crucified to keep German internal inflation under 2pc.” Welcome to the club, Mr. Evans-Pritchard — that is just what I have been saying. I think the most plausible story of what is going to happen next is that Europe will try to have PIIGS deflation for a while; then it will not work, so there will be another crisis, probably political; then we will have one of the solutions that will work, i.e. fiscal union or enough ECB action to create inflation in Germany. Because I think the crisis will rumble on, I remain short EUR and risk assets.

Last week I speculated about the reason for the market’s strong rally after the central banks announced the institution of swap lines. I said that a fall in the probability of an extreme outcome could be the reason, and presented a simple model in which an 8% fall in the probability of such an outcome could lead to a 4% rise in the equity market. Reading Daniel Kahneman’s book over the weekend, I found a better explanation: people sometimes exaggerate the likelihood of unlikely outcomes AND apply weightings to them that are higher than their probabilities. An 8% change in weighting in the calculation, which my model required, can be consistent with a much smaller change in the actual probability of an unlikely event. As I read Kahneman’s book, hich presents a two-system model of the mind, I keep finding support for an idea I was already toying with, that much market behaviour is simply system 1 writ large. If one assumes (not unreasonably) that people’s rational appraisals of the market — a system 2 operation — are evenly balanced between bullish and bearish at any time, it makes sense to think that the aggregate effect of system 1 processes is what moves the market in the short term. How useful this idea will be I am not sure, and I am yet to grasp the limitations of the theory (essential to become an expert user of any theoretical tool), but I am sure that there is at least something in it. If you do not know what I am talking about, I cannot recommend strongly enough that you read Kahneman’s excellent introduction (http://j.mp/uOrb8h).

On 22nd November, I said that, “the fact that [the payroll tax cut and extended unemployment benefits] have been extended before suggests that it is possible they might be again.” I was much less worried than the market appeared to be that these measures would expire. Now Senator Harry Reid is reportedly working in a compromise plan that would see the extension funded by current or future spending cuts, in order to assuage the concerns of the Tea Party (as ever more Mad-Hatter than Boston). No mention is made in the Bloomberg report of the other expiring measures — discretionary spending caps from the debt-ceiling agreement, troop drawdowns and small expiring tax provisions, together totalling 0.5% of GDP — and that suggests to me that US fiscal policy is on course to be at least mildly contractionary in 2012.

Data:

Initial Claims 402k d.e.

ISM rose from 50.8 to 52.7, b.e. and roughly in line with the 52.3 I estimated last week.

Vehicle sales 13.6m b.e. Nov. Another increase. This suggest PCE durable goods will rise 1.29% in November, and may presage further relatively strong data flow from the US.

Japan capital spending -9.8% QoY. d.e.

Non-farm payrolls 120k ~a.e. Nov. Still relatively anaemic.

Unemployment fell to 8.6% b.e. Nov. Of those who left the unemployment roll, roughly half went into jobs and half left the labour force.

Average hourly earnings -0.1% d.e. Nov.

Australia services PMI fell to 47.7.

Eurozone services PMI was revised down a little from the flash estimate to 47.5, still a MOM increase.

UK services PMI 52.1 b.e. and rose. Is this just volatility?

Eurozone retail sales 0.4% b.e. Oct. Eurostat takes so long to publish useful data it should be classed as a historical rather than a statistical organisation.